Next video:
Loading the player...

According to the liquidity preference theory, investors prefer to keep their money liquid -- or as cash -- and they demand interest in return for sacrificing their liquidity.

Investors will pay more for short-term debt and the liquidity that comes with it. They’ll also look for higher interest rates before taking on longer-term debt.

For example, say an investor can choose between a 3-year Treasury note that pays 1 percent interest, a 10-year Treasury note that pays 3 percent, and a 30-year bond that pays 4 percent.

By choosing the 3-year note, he’ll have faster access to his money. But the other choices provide higher interest rates in exchange for less liquidity.

Famed 20th century economist John Maynard Keynes first wrote about the theory. Keynes believed people hold money for three reasons:

  1. To conduct everyday transactions, such as paying rent and bills.
  2. As a precaution for unforeseen expenses, such as unemployment or sickness.
  3. To use for speculation – to have in liquid form to take advantage of favorable changes in interest rates.

Keynes theorized the amount of money investors hold varies inversely with the rate of interest – if rates decrease, they’ll hold more money until rates increase.

Related Articles
  1. Investing

    Understanding Financial Liquidity

    Understanding how this measure works in the market can help keep your finances afloat.
  2. Trading

    Giants Of Finance: John Maynard Keynes

    This rock star of economics advocated government intervention at a time of free-market thinking.
  3. Insights

    What is Liquidity Risk?

    Liquidity risk is the risk of being unable to sell an asset fast enough to avoid loss.
  4. Investing

    Understanding Liquidity Risk

    Make sure that your trades are safe by learning how to measure the liquidity risk.
  5. Investing

    Understanding Liquidity Risk

    Learn about the two types of liquidity risk: funding liquidity risk and market liquidity risk.
  6. Insights

    Seven Decades Later: John Maynard Keynes' Most Influential Quotes

    It's been 71 years since the influential economist died, here are some of his most influential quotes.
  7. Investing

    Interest Rate Predictions With Expectations Theory

    The expectations theory uses long-term interest rates to predict future short-term interest rates.
  8. Insights

    Can Keynesian Economics Reduce Boom-Bust Cycles?

    Learn about a British economist's proposed solution to a common economic problem.
  9. Financial Advisor

    What Is The Quick Ratio?

    Find out about this liquidity indicator and how it's used.
  10. Financial Advisor

    Small Cap Investing: How to Think About Illiquidity

    Do your homework, have a long term view, exercise patience, you'll find that investing in small market capitalization stocks is no riskier than investing in large stocks
Hot Definitions
  1. Salvage Value

    The estimated value that an asset will realize upon its sale at the end of its useful life. The value is used in accounting ...
  2. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  3. Promissory Note

    A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on ...
  4. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  5. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
  6. Absolute Advantage

    The ability of a country, individual, company or region to produce a good or service at a lower cost per unit than the cost ...
Trading Center